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Islamic Capital Markets - Understanding Sukuk

Sukuk, commonly known as Islamic bonds, have become synonymous with Islamic finance in recent years. Following the first US$ 150 million international sukuk issuance by Kumpulan Guthrie Berhad in 2001 and a similar issuance by the Malaysian government in 2002, the total sukuk outstanding have to date reached almost US$ 300 billion.

Despite witnessing phenomenal growth over the last decade and a half, sukuk still represent a relatively small proportion of the global debt markets (global bond market size being approximately US$ 86 trillion). This means that there is still plenty of room for the sukuk market to grow, especially in relatively untapped Muslim majority markets such as Iran, Pakistan and Bangladesh.

So are sukuk really the Islamic equivalent of a conventional bond? The answer is both yes and no. Strictly speaking, a bond represents an obligation of the issuer / borrower to repay a certain sum of money on maturity along with periodic coupon or interest payments. Islam does not permit interest and therefore, a sukuk in that sense is not a bond. Sukuk, as described in AAOIFI’s shariah standard 17, are “certificates of equal value which represent an interest in an underlying tangible asset, usufruct or service or (in the ownership of) the asset of particular project or special investment activity”. In theory at least, the repayment of a sukuk is linked to the return generated by the asset, project or investment activity underpinning the sukuk certificate. Accordingly, whereas an investor takes a credit risk on the issuer under a conventional bond, its exposure under a sukuk is against the performance of the underlying asset or business activity represented by the sukuk. In practice however, the originator, or the entity which provides the assets and receives the investors’ funds, will have granted an undertaking to repurchase the assets on the occurrence of a default at a value equal to the principal and accrued profit amount. In addition, the originator’s repayment obligation with be backstopped by a third party guarantee or liquidity facility, thereby transferring the credit risk back to the originator and/or guarantor. In that respect, although structured differently, the economic effect of a sukuk is similar to that of a conventional bond.

From a documentation standpoint, sukuk documents look similar to, and are in fact based on documentation developed for conventional bonds. The investors or arrangers enter into a subscription agreement with the issuer, usually an offshore special purpose vehicle (SPV) incorporated for this purpose, under which they agree to subscribe to the sukuk certificates. The sukuk certificates themselves are constituted as trust certificates pursuant to a declaration of trust by the SPV (in its capacity as trustee) over its rights and interests in the underlying Islamic finance documentation, and all moneys received thereunder. This has become the preferred structure because the assets underpinning the sukuk need to be separated from other assets of the originator. These assets are therefore transferred to the SPV and form the basis of the Islamic finance transaction. In a sukuk, the SPV acts as the issuer, trustee and financier.

The SPV enters into Islamic finance agreements with the originator whereby the subscription moneys are made available to the originator. The Islamic structure will usually take the form of an ijara, murabaha, wakala or any other structure depending on the nature of the underlying assets. The originator is obliged to repay the SPV under the Islamic finance documents and all payments made by the originator to the SPV (as financier) are passed on by the SPV, as trustee, to the sukuk certificateholders, as the beneficiaries of the trust.

The SPV is established as an orphan entity in a low tax jurisdiction in order to avoid taxes, transfer charges and minimise insolvency risk. As the SPV is unable to administer or enforce its rights under the transaction documents, it will typically appoint a professional trustee services company to act as its delegate. The delegate will exercise the rights and powers, and fulfil the obligations of, the SPV (as trustee) under the transaction documents. The delegate also acts on behalf of the sukuk certificateholders as a class to enforce their rights against the originator. As the SPV does not possess any assets other than its rights under the transaction documents, the investors do not have any recourse against the SPV.

Whereas the SPV doubles up as issuer and trustee in a sukuk issuance, under a conventional bond structure, the issuer and the trustee are separate entities. In a conventional bond, the trustee will declare a trust over (amongst other things) (i) the issuer’s covenant to pay the trustee; and (ii) the issuer’s undertaking to meet its obligations under the terms and conditions of the bond instrument. Unlike a sukuk, the investors in a conventional bond have direct recourse against the issuer, but for administrative convenience the trustee acts on their behalf. The trustee in a conventional bond will usually be a professional trustee services company which acts on behalf of the bondholders as a class and enforces their rights against the issuer on the occurrence of a default. This is the same role performed by the delegate under a sukuk.

As with a bond issue, a paying agent, transfer agent and possibly a registrar will be appointed to manage payments under, and transfers of, the sukuk instruments. Most sukuk are issued as global certificates with the custodian sometimes assuming the additional role as the paying agent. Ownership is recorded through sub-accounts held at the clearing systems but a separate register may also be maintained by a registrar in case of registered certificates.

One of the key features of any capital markets instrument is liquidity. Whether a sukuk is tradeable depends on the underlying Islamic finance structure, with a certain minimum amount of tangible assets required for the sukuk to be traded at a value other than par. This restriction has its roots in the Islamic prohibition against interest, since trading debt at a value other than at par gives rise to interest. Depending on the shariah board involved, the requirement to have a minimum proportion of tangible assets could vary between 33 to 75% of the underlying sukuk assets.

A common misconception about sukuk is that they are asset backed securities with the investors having direct recourse to the underlying assets. Although the sukuk represent an interest in the underlying assets, they are structured such that on the occurrence of a default, the assets are sold back to the originator pursuant to a purchase undertaking; a claim over the assets is therefore replaced by a debt claim against the originator. As such, the ultimate risk under both sukuk and conventional bonds is against the originator/issuer. A few sukuk have, however, been issued as asset backed instruments, the Nakheel, East Cameron Partners and Pakistan motorway sukuk being the most prominent ones. However the vast majority of sukuk issued in recent years are asset based with investors having no recourse to the underlying assets.